CEO compensation and strategic expenses: penalizing, shielding or rewarding?

The purpose of this paper is to investigate the way in which CEOs are shielded or rewarded for incurring R&D expenses. Strategic expenses such as R&D yield returns over a long period of time even though GAAP requires them to be written off in the period they are incurred. Going beyond the existing shielding paradigm, the paper investigates whether compensation committees actively reward CEOs for incurring strategic expenses.

The paper uses empirical analysis by using regression analysis with CEO compensation (both cash and equity) as the dependent variable and firm size, firm performance, earnings risk, market‐to‐book ratio, R&D expenses, advertising expenses and governance variables as control, independent and test variables.

The paper shows that CEOs are not only shielded but are actively rewarded for incurring R&D expenses. The paper also shows that the shield/reward effects are stronger in manufacturing firms. Finally, the paper shows that independent compensation committees increase rewards for R&D expenses.

Given the small sample of firms with advertising expense data, a larger sample, possibly using hand‐collected data will be required to arrive at definitive conclusions regarding shielding/rewarding for advertising. Furthermore, the shielding of both R&D and advertising expenses should be looked at in conjunction with the duration of the persistence of benefits of such strategic expenses.

This paper shows how compensation committees can use compensation to induce executives to undertake strategic expenses on behalf of the firm.